Under the Indian law relating to companies, a public company is managed by a Board of Directors which is entrusted with the responsibility of managing the company in the most efficient and transparent manner.
However, in an era of recurring business scams, it would not be astonishing if the prospective shareholders feel insecure about investing in a particular company.Over the years, the shareholders have been given various tools to keep a check on the methods and practices adopted by the directors of a company for its internal management, but to what extent can one go in finding out about such methods and practices, is the question to which the answer remains ambiguous. Nevertheless, some explanation in this regard can be sought in the Turquand's Rule or the Doctrine of Indoor Management.
'Doctrine of Indoor Management', popularly known as the Turquand’s Rule initially arose from 150 years ago in the context of the 'Doctrine of Constructive Notice'. The rule of the doctrine of indoor management is opposed to the rule of constructive notice. The latter seeks to protect the company against the outsider while the former seeks to protect the outsiders against the company.
The rule of constructive notice is confined to the external position of the company, and therefore, it follows that there is no notice as to how the company's internal machinery is handled by its officials. If the contract is consistent with the public documents, the person contracting will not be prejudiced by irregularities that may beset the indoor working of the company.
The Doctrine of Indoor Management lays down that persons dealing with a company having satisfied themselves that the proposed transaction is not in its nature inconsistent with the memorandum and the articles, are not bound to inquire the regularity of any internal proceeding. In other words, while persons contracting with a company are presumed to know the provisions of the contents of the memorandum and articles, they are entitled to assume that the officers of the company have observed the provisions of the articles.
It is no part of duty of any outsider to see that the company carries out the requisite internal proceedings. It is important to note that the rule of constructive notice can be invoked by the company and it does not operate against the company. It operates against the person who has failed to inquire but does not operate in his favour.
DOCTRINE OF CONSTRUCTIVE NOTICE
Every outsider dealing with a company is deemed to have notice of the contents of the Memorandum and the Articles of Association. These documents, on registration with the Registrar, assume the character of public documents. This is known as 'constructive notice' of Memorandum and Articles.
The Memorandum and the Articles are open and accessible to all. It is the duty of every person dealing with a company to inspect these documents and see that it is within the powers of the company to enter into the proposed contract. Likewise special resolutions, when registered with the Registrar, become public documents, so that an outsider is on notice of their contents in the same way as he is of the Articles and the Memorandum. Thus, anyone dealing with a company is presumed not only to have read the Memorandum and the Articles but to have understood them properly.
Kotla Venkatswamy v. C. Rammurthi
The Articles of Association of a company contained a clause that all deeds and documents of the company shall be signed by the managing director, the secretary and a working director on behalf of the company. A deed of mortgage was signed by the secretary and a working director only.
It was held that the mortgage could not be enforced as the illegality appeared on the face of the deed, and therefore, the deed was invalid notwithstanding that plaintiff acted in good faith and money was applied for the purposes of the company.
The doctrine of constructive notice of the Memorandum and Articles, however, is not a positive doctrine but a negative one. It is like doctrine of estoppels. It does not operate against the company. It operates only against an outsider dealing with the company. It prevents him from alleging that he did not know that the Memorandum and Articles rendered a particular act ultra vires the company.
STATUTORY REFORM OF CONSTRUCTIVE NOTICE
Constructive notice is more or less an unreal doctrine. It does not take notice of the realities of business life. People know a company through its officers and not through its documents. Section 9 of the European Communities Act, 1972 has abrogated this doctrine. The provisions of Section 9 are now incorporated in Section 35 of the Companies Act, 1985 under the English law.
An example of the impact of the new provisions has been provided by a famous English case where a debenture issued by a company was signed by a solicitor as attorney of a director of the company, but not by the director personally. The articles of the company provided that "every instrument to which the seal shall be affixed shall be signed by a director". Even so the company was held liable. Stating the effect of the new provision, the court said that before this enactment came into force a person dealing with the company was required to look at the memorandum and articles of the company to satisfy himself that the transaction was within the corporate capacity but that Section 9(1) has changed this.
The sub-section provides that good faith is to be presumed and that the person dealing with the company is not bound to inquire. The expression "a person dealing with a company" has not been held not to include a shareholder allottee. The court refused to validate an allotment of bonus shares by using the share premium account without authorization.
The courts in India also do not seem to have taken the rule of constructive notice seriously. For example, in Dehradun Mussoorie Electric Tramway v. Jagmandardas, the articles of a company expressly provided that the directors could delegate all their powers except the power to borrow. Even so an overdraft taken by the managing agents without approval of the board was held to be binding, the court saying that such temporary loans must be kept outside the purview of the relevant provision.
GENESIS OF THE DOCTRINE
The Rule of Doctrine of Indoor Management had its genesis in the English case Royal British Bank v. Turquand. In this case, the directors of the company were authorized by the Articles to borrow on bonds such sums of money as should from time to time by a special resolution of the Company in a general meeting, be authorized to be borrowed. A bond under the seal of the Company, signed by two directors and the secretary was given by the Directors to the plaintiff to secure the drawings on the current account without the authority of any such resolution.
Then Turquand sought to bind the Company on the basis of that bond. Thus, the question arose whether the company was liable on that bond. The Court of Exchequer Chamber overruled all objections and held that the bond was binding on the Company as Turquand was entitled to assume that the resolution of the Company in general meeting had been passed.
The rule is based upon obvious reasons of convenience in business relations. Firstly, the memorandum and articles of association are public documents and are thus, open to public inspection. But the details of internal procedure are not open to public inspection. Hence an outsider "is presumed to know the constitution of a company; but what may or may not have taken place within the doors that are closed to him".
The rule is of great practical utility. It has been applied in a great variety of cases involving rights and liabilities. It has been used to cover acts done on behalf of a company by de facto directors who have, for instance, never been appointed, or whose appointment is defective, or who, having been regularly appointed, have exercised an authority whish could have been delegated to them under the company's articles, but never has been so delegated, or who have exercised an authority without proper quorum etc.
Thus, where the directors of a company having the power to allot shares only with the consent of the general meeting, allotted them without any such consent; where the managing director of a company granted a lease of the company's properties, something which he could do only with the approval of the board; where the managing agents having the power to borrow without any such approval, the company was held bound.
EXCEPTIONS TO THE DOCTRINE OF INDOOR MANAGEMENT
The rule is now more than a century old. In view of the fact that companies having come to occupy the central position in the social and economic life of modern communities, it was expected that its scope would be widened. But the course of decisions has made it subject to the following exceptions:
Knowledge of Irregularity
Where a person dealing with a company has actual or constructive notice of the irregularity as regards internal management, he cannot claim the benefit under the rule of indoor management. He may in some cases, be himself a part of the internal procedure. The rule is based on common sense and any other rule would "encourage ignorance and condone dereliction of duty". Some instances in this regard are as follows:
T.R. Pratt (Bombay) Ltd. v. E.D. Sassoon & Co. Ltd.
Company A lent money to Company B on a mortgage of its assets. The procedure laid down in the Articles for such transactions was not complied with. The directors of the two companies were the same. It was held in this case that the lender had notice of the irregularity and hence the mortgage was not binding.
A transfer of shares in a company was approved by two directors. One of these directors was not validly appointed. The other was disqualified by reason of being the transferee himself. These facts were known to the transferor. It was held in this case that the transfer was ineffective.
Where a person dealing with a company could discover the irregularity if he had made proper inquiries, he cannot claim the benefit of the rule of indoor management. The protection of the rule is also not available where the circumstances surrounding the contract are so suspicious as to invite inquiry, and the outsider dealing with the company does not make proper inquiry. If, for example, an officer of a company purports to act outside the scope of his apparent authority, suspicion should arise and the outsider should make proper inquiry before entering into a contract with the company.
Anand Bihari Lal v. Dinshaw & Co.
The plaintiff, in this case, accepted a transfer of a company's property from its accountant. It was held in this case that the transfer was void as such a transaction was apparently beyond the scope of the accountant's authority. The plaintiff should have seen the power of attorney executed in favour of the accountant by the company.
The rule in Turquand's case does not apply where a person relies upon a document that turns out to be forged since nothing can validate forgery. A company can never be held bound for forgeries committed by its officers. The leading case on this point is:
The plaintiff was the transferee of a share certificate issued under the seal of the defendant company. The certificate was issued by the company's secretary, who had affixed the seal of the company and forged the signatures of two directors. The plaintiff contended that whether the signatures were genuine or forged was a part of the internal management and, therefore, the company should be estopped from denying genuineness of the document.
But it was held that the rule has never been extended to cover such a complete forgery. Lord Loreburn said "It is quite true that persons dealing with limited liability companies are not bound to inquire into their indoor management and will not be affected by irregularities of which they have no notice. But this doctrine, which is well established, applies to irregularities which otherwise might affect a genuine transaction. It cannot apply to a forgery".
This statement has been regarded as a dictum, as the case was decided on the principle that the secretary did not have actual or implied authority to represent that a forged document was genuine and, therefore, there was no estoppel against the company. Hence, a general statement that the Turquand Rule does not apply to forgeries is not exactly warranted by the present authorities.
Representation through Articles
This exception deals with the most controversial and highly confusing aspect of the Turquand Rule. Articles of association generally contain what is called the "power of delegation".
Lakshmi Ratan Cotton Mills v. J.K. Jute Mills Co.
This case explains the meaning and effect of a delegation clause.
One G was a director of a company. The company had managing agents of which also G was a director. Articles authorized directors to borrow money and also empowered them to delegate this power to any one or more of them. G borrowed a sum of money from the plaintiffs. The company refused to be bound by the loan on the ground that there was no resolution of the board delegating the power to borrow to G. Yet the company was held bound by the loan.
Thus the effect of a delegation clause is that a person who contracts with an individual director of a company, knowing that the board has power to delegate its authority to such an individual, may assume that the power of delegation has been exercised.
Acts outside the scope of apparent authority
If an officer of a company enters into a contract with a third party and if the act of the officer is beyond the scope of his authority, the company is not bound. In such a case, the plaintiff cannot claim the protection of the rule of indoor management simply because under the Articles the power to do the act could have been delegated to him. The plaintiff can sue the company only if the power to act has in fact been delegated to the officer with whom he has entered into the contract.
Kreditbank Cassel v. Schenkers Ltd.
A branch manager of a company drew and endorsed bills of exchange on behalf of the company in favor of a payee to whom he was personally indebted. He had no authority from the company to do so. It was held that the company was not bound. But if an officer of a company acts fraudulently under his ostensible authority on behalf of the company, the company is liable for his fraudulent act.
Sri Krishna v. Mondal Bros.& Co.
The manager of a company had the authority under the Memorandum and the Articles of the company to borrow money. He borrowed money on a hundi but did not place the money did not place the money in the coffers of the company. It was held that the company was bound to honour the hundi. It could not defeat the bona fide claim of the creditor for recovery of the money on the ground of fraud of its own officer.
POSITION UNDER THE INDIAN COMPANIES ACT, 1956
The provision under the Indian Companies Act, 1956 which directly imbibes the Turquand’s Rule is Section 290, which reads as follows:
Validity of acts of directors:
Acts done by a person as a director shall be valid, notwithstanding that it may afterwards be discovered that his appointment was invalid by reason of any defect or disqualification or had terminated by virtue of any provision contained in this Act or in the Articles:
Provided that nothing in this Section shall be deemed to give validity to acts done by a director after his appointment has been shown to the company to be invalid or to have terminated.
The case of Royal British Bank v. Turquand refined the common law of agency to articulate the Doctrine of Indoor Management. The rule was enunciated by the Court to mitigate the rigors of the Doctrine of Constructive Notice. The rule protects the interest of the third party who transacts with the company in good faith and to whom the company is indebted. The gist of the rule is that persons dealing with a public company are not bound to enquire into their indoor management and will not be affected by irregularities of which they had no notice.
The Turquand Rule has been applied in many cases subsequently and generally in order to protect the interests of the party transacting with the directors of the company. With the due course of time several exceptions have also emerged out of the rule like forgery, negligence, acts done outside the scope of apparent authority and third party having knowledge of irregularity etc. If we analyze the cases it is revealed that the Turquand Rule did not operate in a completely unrestricted manner.
Firstly, it is inherent in the rule that if the transaction in question could not in the circumstances have been validly entered into by the company, then the third party could not enforce it. Secondly, the rule only protects 'outsiders', that is persons dealing with the company externally; directors, obviously were the very people who would be expected to know if the internal procedures had been duly followed.
Thirdly, actual notice of the failure to comply fully with the internal procedures precluded reliance upon the rule. Lastly, an outsider could not rely upon the Turquand's Rule where the nature of the transaction was suspicious, for example, where the company's borrowing powers were exercised for purposes which were wholly unconnected with the company's business and of no benefit to the company.